Special Report on Investment Trusts (3): Tax-efficient way to divide up the spoils: The split capital trusts can meet a variety of requirements, from boosting income to planning school fees
Wednesday 20 January 1993
These trusts have many different types of shares to suit different taxation requirements. There are shares for investors who want a large income but no capital gain, and for investors who want a capital gain but no income.
Stephen Trowbridge, a director of the Liverpool stockbroker B W D Rensburg, said: 'When the investment trust industry was running scared five to six years ago . . . they came up with split capital trusts. Basically they split investment trusts down into, say, three or four interesting tax-planning parts. So instead of having one bog-standard trust, you have different types of share, some of which are entitled to the trust's income, some to the capital gain and so on.'
Split capital trusts are particularly tax-efficient for purposes such as inheritance tax planning, school fees savings plans, and as an alternative to gilts.
These investment trusts have an underlying portfolio of shares just like any other, but unlike others they split up the capital gains on the portfolio and the dividends and allocate them to different types of share. They also have a set date on which to be wound up.
They proliferated in the second half of the 1980s, at a time when the investment trust industry was desperate to attract new investors, because they proved to be particularly popular with investors who wanted to minimise their tax bills.
Before then, there were some split capital investment trusts, but they were typically comparatively simple savings vehicles with only two types of share. One type was the income share which was entitled to all of the income in the split capital investment trust's underlying portfolio, and the other type was the capital share which was entitled to all the capital growth.
But as more and more investment trust houses launched split capital trusts, so the variety of share grew in number. The most common types today are called zero dividend preference, income, and capital. Split capital trusts may comprise of all or just some of these types of share.
Zero dividend preference shares are perhaps the most favoured for tax purposes. As their name suggests they pay no dividends, but have first claim to the trust's capital when it is wound up.
They are issued at a certain price and redeemed at a predetermined higher price when the trust is wound up. So their capital value should steadily increase until that time.
Income shares are generally entitled to most of the dividends earned by a trust's underlying portfolio of shares. Some of these are designed to hold their capital value, but pay out a high income. Others, often dubbed 'annuity' shares, are designed to pay out an even higher income, but lose most if not all of their capital value.
Capital shares are entitled to all or most of the capital in a portfolio after the preference shares have been paid off. As a result they tend to exaggerate the capital movements of the underlying portfolio and are said to be 'geared'.
Mr Trowbridge says split capital shares minimise taxation when used for the following purposes:
(1) School fees planning. He recommends that a parent planning for school fees should buy zero dividend preference shares in the child's name. Like adults, children have a pounds 5,800 annual capital gains tax allowance and so this is highly tax-efficient.
More optimistic parents, 'and you've got to be optimistic if you are planning to pay school fees these days', might also top up the holding of zeros with capital shares, he said. But this is only for those who are optimistic about the stock market's prospects and prepared to take a loss on the capital shares if they are wrong.
(2) Inheritance tax planning. He recommends that parents who wants to give away capital early enough to live for another seven years and avoid inheritance tax but maintain an income in the meantime buy zeros for their children and income shares for themselves.
(3) Alternative to gilts. Zeros have a similar total return to gilts and are a handy alternative for investors who do not use their pounds 5,800 annual capital gains tax allowance. Mr Trowbridge advises that by selling part of the capital gain each year, an investor can effectively get a tax-free income.
But Lewis Aaron, a senior investment trust analyst at S G Warburg Securities, warns that investors should make sure they are well advised before buying these investments. The zeros are not guaranteed and there is a risk they might not make the capital gain anticipated; an investor should make sure he is aware of whether an income share is an 'annuity' or not; and some capital shares are more highly geared than others.
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